The ECB’s Balance Sheet and Draghi’s Confidence Game

Yves here. This post provides a high level summary and assessment of the ECB’s post-crisis conduct. Among other things, it demonstrates that the ECB makes the Fed look good. Some readers will take issue with the fact that Mody treats QE as a reasonable policy, when the experimental policy has goosed asset markets without doing much for the real economy. It has hurt savers by flattening the yield curve and reducing yields on longer-term investments and many economists believe it has exacerbated income inequality, which is increasingly seen as a drag on growth. However, the hair shirt of the Masstricht treaty rules out fiscal stimulus, and most economists accept the view that monetary stimulus is better than standing pat.

By Ashoda Mody, Charles and Marie Robertson Visiting Professor in International Economic Policy at the Woodrow Wilson School, Princeton University. Originally published at Bruegel

In his press conference on November 6th, ECB President Mario Draghi pledged monetary stimulus, although only “if needed.” His exact statement was: “The Governing Council has tasked ECB staff and the relevant Eurosystem committees with ensuring the timely preparation of further measures to be implemented, if needed.” In response to questions from journalists, he mechanically repeated the phrase, “if needed” four times. A fortnight later—on November 21st in Frankfurt—in a speech that drew much attention for promising bold new action, President Draghi coined a new phrase: “We will do what we must,” echoing his famous “whatever it takes.” He said: “We will do what we must to raise inflation and inflation expectations as fast as possible;” but he repeated verbatim: “the Governing Council has tasked ECB staff and the relevant Eurosystem committees with ensuring the timely preparation of further measures to be implemented, if needed.”

The “if needed” theme appeared earlier on October 9 in a speech Mr. Draghi delivered at the Washington-based think tank, the Brookings Institution. His prepared remarks said: ““We are ready to alter the size and/or the composition of our unconventional interventions, and therefore of our balance sheet, as required.”

the ECB is behind the curve even as a debt-deflation cycle is ongoing in the so-called “periphery.”

These words have won Mr. Draghi many admirers for his determination to move decisively forward. But the actions tell a different story. The “if needed” mantra is only the most recent example of the ECB’s congenital conservatism in dealing with the ever-unfolding crisis. Once again, the ECB is behind the curve even as a debt-deflation cycle is ongoing in the so-called “periphery.” Rather than a central bank that helps revive growth and inflation, the ECB has become a safety net for dealing with near-insolvency conditions. Its coyly-stated target of an additional trillion euros in balance sheet expansion will not occur and, if it does, would have a trivial effect. By consistently using words while failing to act in time, the ECB is eroding its hard-won credibility.

The Eurozone’s Debt-Deflation Cycle

According to the latest Eurostat data, in October, the 12-month average inflation rate in the eurozone was 0.6%; it was 0.3% for Italy, 0.0% for Spain, and -0.1% for Portugal. In his November 21st Frankfurt speech, Mr. Draghi claimed that such low inflation not foreseen. “Last November,” he said, “[inflation] still stood at 0.9%. This was low, but it was generally expected to rise safely above 1% by now.”

The claim that in November 2013 inflation was “generally” expected to rise is puzzling. Already in April, Guntram Wolff  warned of deflationary pressures. And by November, futures markets were projecting annual inflation at below 0.9%.  The risk of an out-of-control cycle of rising debt and falling inflation was manifest. And since fighting deflation is harder the more entrenched it is, at least one commentator urged prompt action in January this year: “the ECB’s insistence on waiting for more evidence of deflation is a dangerous gamble.”

Finally, on June 5th, with mounting evidence that inflation would not turn up on its own, the ECB did announce several new measures. These were intended “to provide additional monetary policy accommodation and to support lending to the real economy.”  But did the measures match the task at hand?

  • Zsolt Darvas and Pia Hüttl pointed out, the lower policy rate could be expected to have little effect since banks were already drawing down their reserves at the ECB.
  • Silvia Merler was skeptical of the “targeted long-term refinancing operations (T-LTROs)” to stimulate lending. Indeed, a Wall Street Journal survey of market participants on September 18th concluded: “Well it seems that not all banks have gone gung-ho for the European Central Bank’s first longer-term refinancing operations, or TLTRO.” Even if there had been more interest, Wolff was concerned that the measure would delay needed restructuring of banks while it did little to improve monetary conditions.
  • Finally, Carlo Altomonte and Patrizia Bussoli quickly did the numbers and explained that the highly-touted program for the purchase of asset-backed, or rebundled, securities would make little difference because the size of the asset-backed securities market was too small. More bluntly, Jacques de Larosiere, the former head of the International Monetary Fund, told Reuters on November 20th, “It is a strategy with little prospect of success.” Because the ECB cannot assume the risk of default, it is limited to the purchase of only the safest slices of the already small market for rebundled securities. The ECB’s calls to others with deep pockets for help went, understandably, unheeded. And, as expected, miniscule quantities were purchased in the inaugural round.

Ironically, now that Mr. Draghi is openly concerned about persistent low inflation, he seems to have run out of instruments to counter the tendency. For this reason, it helps him and his colleagues to claim that the June 5th measures will eventually be effective. But just like the forecasts last year projected higher inflation, the new claim has no support in logic or evidence.

For anyone who wants to see it, a debt-deflation cycle is ongoing in the distressed economies. Scary though they are, the focus on the eurozone headline numbers is somewhat besides-the-point. The focus should be on Italy, Portugal, and Spain. In a recent blog post, Giulio Mazzolini and I showed that countries experiencing faster-than-expected increase in their debt-to-GDP ratios are also those experiencing faster-than-expected fall in inflation. In other words, the authorities have very nearly lost control of a process that will become ever harder to manage as it becomes more entrenched. The ECB’s measures are woefully behind the curve.

Is the ECB Irrelevant?

In October 2008, right after Lehman Brothers filed for bankruptcy, the major central banks stepped in to provide desperately needed liquidity to banks and financial markets. Figure 1 shows the expansion of the balance sheets relative to the GDP, normalized to 100 in January 2007 (to eliminate the pre-crisis differences due to variations in financial structures). Even at that existential moment, the ECB’s actions were much more conservative than those of the U.S. Federal Reserve or the Bank of England.

More importantly, a sizeable fraction of the increase in the ECB’s balance sheet was to support the Belgian and French banks, which meant, in effect, Fortis and Dexia. Since Dexia has remained distressed, the support it received was as much to prevent it from filing for insolvency as it was to provide temporary liquidity. This distinction between liquidity and solvency took center stage in mid-2011.

ECB Draghi 1

Market’s expectation of how long policy rate will remain low determines the extent of decline in long-term interest rates

A central bank can undertake two principal actions: actively stimulate the economy and passively promote lending (see Hetzel, 2012, especially chapters 14 and 16 for the theory and application to the Great Recession in the United States). Active monetary stimulus of the economy is normally achieved by reducing its policy interest rate. The market’s expectation of how long the policy rate will remain low determines the extent of the decline in long-term interest rates and the consequent increase in investment. When the policy rate falls to zero, the central bank can buy financial assets to directly lower the long-term interest rate, an action often described as “quantitative easing.”

In contrast to active monetary stimulus, the central bank can passively provide funds to banks in the hope they will lend more to release credit constraints on economic growth. However, there is no guarantee that the banks will use their easier access to funds for new lending.

By these conventional categories, the ECB provided no active stimulus. Policy interest rate reductions always lagged behind the fall in activity; indeed, interest rates were raised in 2008 and, more disastrously, in 2011 (Hetzel, 2014). And, the ECB has been virtually absent in the purchase of assets to directly influence long-term rates.

The ECB did provide banks with additional “liquidity.” But, in doing so, it acted in a manner highly unusual for central banks. For an extended period, the ECB’s so-called liquidity operations have, in effect, propped up insolvent banks and have thus been a giant exercise in forbearance.

Consider the evidence. The rise in the ECB balance sheet from June-2011 to June-2012 tracks the rise of its so-called Target 2 balances (Figure 2). Before the crisis, banks in the so-called “core” countries had lent large sums to the “periphery” banks. By 2011, the core banks wanted their money back, but the periphery banks, with no alternate source of funding, appeared likely to default on their repayment obligations. Through the Target 2 system, the “core” country central banks lent funds to the “periphery” central banks, who then funded their private banks, allowing the repayment of private periphery debt to the core. Thus, the bulk of Target 2 expansion was used to prevent a wave of defaults rather than provide liquidity to otherwise solvent banks.

ECB Draghi 2

Despite many criticisms, the expansion of the Target 2 balances in 2011-12 was appropriate because it prevented disorderly defaults and panic and, hence, maintained financial stability. But that balance sheet expansion provided no monetary stimulus and, importantly, it was only in part a liquidity operation. Because the expansion was not followed by aggressively closing down or restructuring banks—while inflicting losses on their creditors—the breathing space gained was misused to provide extended regulatory forbearance to weak and insolvent banks.

In the United States, the closest similar action was through the purchase of asset-backed securities, which play a more significant role than in Europe. These purchases helped stabilize U.S. financial markets and, unlike the Target 2 expansion, they also helped lower the long-term interest rate and thus provided monetary stimulus.  Moreover, in the U.S., the insolvency risks were dealt separately by recapitalizing banks (using fiscal resources) or by closing down and restructuring banks (through the Federal Deposit Insurance Corporation).

With time, the Eurosystem’s Target 2 balances have come down, but they remain substantial by any reasonable international norm or the eurozone’s historical standard, pointing to the persistent distress in the European banking system. Even the banks that have stabilized remain weak.

Figure 3 reinforces the view that the key problem lies in viability and solvency of eurozone banks. The repayment of the Target 2 balances has followed the partial recovery of the euro area banks’ market value-to-book ratio (the market value of the banks’ assets relative to the accounting value on their books). Thus, as banks have retrieved some of their lost credibility, they have been able to pay the ECB back.

But even as late as September 2014, the price-to-book value of banks in the Eurozone was still below one. Put simply, several years into the crisis, the financial markets still regard some of the assets on the banks’ books as fictitious. A large segment of the euro area banking system is unable to stand on its own legs and, therefore, requires continued ECB support.

Note: The market-to-book ratio is given by the value of the shares outstanding of the Euro Area banks, divided by the aggregate book value of the same institutions.

ECB Draghi 3

Today, the market is reading into Mr. Draghi’s statements an intention of raising the ECB’s balance sheet by 1 trillion euros to about the 3 trillion achieved in June 2012. How meaningful would that expansion be?

even an increase of 1 trillion euros will make the effective ECB stimulus a small fraction of what the U.S. Federal Reserve achieved

If we stipulate that nearly all of the ECB’s outstanding balance sheet is essentially propping up weak banks, then the current effective monetary stimulus—active or passive—is close to zero. Hence, even an increase of 1 trillion euros will make the effective ECB stimulus a small fraction of what the U.S. Federal Reserve achieved. Moreover, since the measures proposed will almost certainly not accomplish the 1 trillion euro target, whatever expansion does occur will have virtually no stimulative effect.

With the Bank of Japan’s balance sheet now exploding, the ECB is set to remain—by far—the central bank with the tightest, most conservative monetary policy among the major central banks. A measure of the ECB’s conservatism is the dollar/euro exchange rate. At about 1.24 (although down from almost 1.4 seven months ago), the exchange rate is about the same as at the start of the crisis. The U.S. economy is about 9 percent larger than its pre-crisis level while the eurozone economy has struggled to reach that level. Looking ahead, the expected growth rates clearly favor a growing U.S. lead. Yet, the euro has remained about as strong as just before the crisis started.

It is as if the ECB has become irrelevant except to limit the fallout from insolvency risks. The ECB’s balance sheet can hold, or promise to buy, obligations that might otherwise not be honored. This was the case with the Target 2 balances. And this was the case also with the ECB’s “outright monetary transactions (OMT) program,” which offered to buy “unlimited” quantities of sovereign debt. For the OMT, the ECB’s word was enough; for Target 2, the ECB actually helped pay off the obligations of distressed banks in the hope that these banks would eventually recover enough to repay the ECB.

The ECB’s extended support of banking distress is unusual for a central bank. It raises important questions about what exactly the ECB does. It especially raises questions about the ECB’s new role as a bank supervisor. Can the ECB be an effective supervisor while it has an incentive to practice forbearance?


Starting in September 2007 from 5¼%, the U.S. Federal Reserve rapidly lowered its policy rate to a ¼ percent by late-2008. The U.S. Fed also initiated its first QE operations in December 2008.

Throughout, the ECB has been in a reactive mode: delays and half measures have been the norm. In 2007-8, it was obsessed with the threat of inflation, even though the rise in inflation was clearly temporary and the prospects for growth were evidently weakening. Only after the Lehman-induced meltdown in September 2008 did the ECB begin lowering rates. However, the response was always forced and the ECB obsession with inflation continued through mid-2011, when it twice raised interest rates. In October 2011, the ECB policy rate was still 1.5%, reaching a ¼% only in November 2013; and the debate on whether a seriously-sized QE is necessary is still ongoing.

ECB Draghi 4

Even the much-celebrated OMT decision came in the face of an imminent financial collapse. By then, the periphery was badly wounded, and the deep scars acquired then have remained. The ECB spent much of last year denying the risk of deflation. Finally, on June 5th this year it initiated actions that contemporary analysis warned would not be up to the task. And now the promise is to do more, but only if needed.

“Cheap talk” is a legitimate policy tool. With their words, policymakers, especially central bankers, can change expectations and create a self-reinforcing cycle of growth and optimism. But talk can also create a cognitive bubble.

The American philosopher and linguist George Lakoff explains that for those who live in a certain cognitive frame, the metaphors and rhetoric come to have real meaning and debating the details become the source of endless fascination. Mr. Draghi has successfully placed the current focus on the “if needed” metaphor. The ECB’s chief economist, in his November 18th interview with the Financial Times, repeated that the central bank remained “willing to act,” “if needed.” The consensus within the ECB’s Governing Council remains steadfast with a “wait and see” and “won’t rush” approach.

Others play by the rules of the cognitive frame. Thus, despite the serious concerns with the June 5th measures—documented carefully by my Bruegel colleagues—journalists have no interest in asking ECB officials: “What exactly are we waiting for?” The financial markets have no interest in public policy: once the rules are set, they seek opportunities for short-term bets. On July 9th, the International Monetary Fund’s Executive Board somewhat incredulously concluded: “Directors welcomed the exceptional measures recently taken by the European Central Bank (ECB) to address low inflation and strengthen demand, as well as its intention to use further unconventional instruments if necessary.” Belatedly, on November 25th, the OECD became a lone official voice calling for more urgent steps.

In the meanwhile, the futures markets are betting that euro area inflation in the coming year will be about 0.45% and over the next two years will be 0.55%. The continued risk of declining inflation is only partly due to global commodity price trends. The eurozone periphery’s debt-deflation cycle is set to continue, with spillovers through weak demand to the core and beyond that to the rest of the world.

Having delayed so long, if today the ECB were to buy sovereign bonds, as many think it should, the stimulative impact would be negligible

There is some risk that in this cognitive bubble the words create a deceptive sense of forward movement, breeding more inaction. Inaction causes the central bank to lose credibility since even apparently sensible actions lose traction (Bordo and Siklos, 2014). Having delayed so long, if today the ECB were to buy sovereign bonds, as many think it should, the stimulative impact would be negligible. The historically low sovereign yields will fall further: how will that help revive growth or inflation? A shift to a higher inflation target and one that is more “symmetric,” obliging the ECB to act more decisively, could help. But was a target needed to recognize that the euro area is falling into a debt-deflation cycle?

There are four possibilities. First, inflation may turn up, relieving the pressure on the ECB. In the current weak global economy, with China slowing noticeably, the probability of this happening is low. But the euro area may finally get lucky with a rebound in food and energy prices. Second, the ECB actions may have greater impact than the analysis in this blog gives it credit for. Third, the ECB could take truly bold action by coordinating with the US Federal Reserve and other central banks to engineer a substantial depreciation of the euro. And, in that fantasy land, there would also be a sizeable fiscal stimulus. Finally, of course, the drift could continue.

For their generous comments, and without implicating them, I thank Michael Bordo, Ajai Chopra, Guntram Wolff, and especially Giulio Mazzolini who produced the graphics despite the demands on his time before moving on.



Bordo, Michael and Pierre L. Siklos, 2014, “Central Bank Credibility: An Historical and Quantitative Exploration,” Presented at the 2014 Norges Bank Conference “Of the Uses of Central Banks: Lessons from History”, Oslo, Norway.

Hetzel, Robert, 2012, “The Great Recession: Market Failure or Policy Failure,” Cambridge: Cambridge University Press.

Hetzel, Robert, 2014, “Contractionary Monetary Policy Caused the Great Recession in the Eurozone: A New-Keynsian Perspective,” Federal Reserve Bank of Richmond, Working Paper WP 13-07R.

Print Friendly, PDF & Email


  1. Jim Haygood

    This is an excellent survey of monetary policy, but it excludes comment on fiscal policy. In a brief moment of lucidity, Bill Gross addresses both:

    Monetary and fiscal policies must work side by side; they must be stimulative as opposed to being counterproductive. It makes little sense, for instance, for Euroland to be running a tight fiscal policy resembling the balanced budget mandate of Germany, while at the same time initiating quantitative easing and negative interest rate monetary policies.

    It’s been all monetary policy, all of the time, with most of the positives flowing over to markets as opposed to the real economy. The debt currently being created is not promoting real growth and solving a debt crisis – it is being used [in the US] by corporations to repurchase shares and accentuate the growing inequality between the very rich and the middle class.

    How could they have thought that money printing and debt creation could create wealth instead of just more and more debt? How could fiscal authorities have stood by and attempted to balance budgets as opposed to borrowing cheaply and investing the proceeds in infrastructure and innovation?

  2. impermanence

    This is all about bankers attempting to keep the greatest financial scam in the history of mankind going. What a complete joke.

  3. kevinearick

    Vortex AC Kernels

    The universe is a circle with a switch, of switches and circles, a motor-generator, with virtual coil, magnet and armature; prime coils are extremely efficient compilers, because you always have access to relative voltage on one side, zero voltage inside the mirror, and complimentary voltage on the other; faith exists beyond what the current iteration computes (other galaxies have elements that this galaxy does not); and you can collect that which is unseen – leakage, errors, and transients, with titration/distillation in the other direction.

    Build a search engine.

    Public education distills down knowledge assumptions for the sake of scale, peer pressure efficiency. Work is in the other direction. You want to jump circuits, beginning with the return line. You need a stack, with the ability to short and open, an adjustable relative semiconductor potentiometer.

    Work is done uphill. The majority normally travels downhill, following the 10% creating the mythology of make-work. Upon consideration of human natural resource exploitation, to who would you give a time element from another galaxy?

    Equal opportunity is one thing; equal outcomes is another. The former is enabling; the latter is disabling. Value is a frame of reference. Seek that which others do not, in your own spacetime. Speed is not the issue anywhere but in make-work. And gravity has its uses.

    AC + DC = Quantum Backlash

    1. craazyman

      With a mind like yours and the knowledge you have, I’m surprised you didn’t electrocute yourself by accident years ago. I know I would have if I knew enough to experiment with high voltage power. That’s the thing, These dudes in economics labs can run experiments all day and night and there’s no way they can feel anything. They just sit there in a chair. That’s it! Sometimes it’s the coffee machine. Sometimes its the wine bar. Sometimes its a fancy restaurant. All the time it’s talk talk talk. “But the euro area may finally get lucky with a rebound in food and energy prices.” oh man, then they can talk with the boot harder on the neck and the wine glass higher in the air — for balance. they won’t know one way or the other.

      1. kevinearick

        a lot of electricians and non-electricians have electrocuted themselves, thinking that I was the one trapped in the elevator with no exit.

        My pop handled hot at US Steel substations, back when WWII was on the horizon, and the other Germans thought they had the best tanks / heat sinks.

  4. kevinearick

    I don’t think the critters ever figured out what those lights were doing on the radio antennas, or why pop liked to climb up and down the frames all the time.

  5. Oregoncharles

    ” the Masstricht treaty rules out fiscal stimulus,” (2 a’s in Maastricht, not that it really matters) –
    doesn’t this mean that the treaty, and the fundamental design of the Euro, is the real culprit? Looks like Draghi doesn’t matter all that much.

  6. MikeNY

    Draghi has been supremely vociferous in telling the markets that the ECB will act, if necessary. But it is apparently never necessary.

    It feels increasingly like bluff.

  7. steviefinn

    I don’t know, I am just guessing, but could it be that Draghi & the other Troika members are also intent on using the dead cat bounce economies in the periphery to make it easier to enforce austerity measures, by using the conditions to declare that these & other economies are not working properly & need to be reformed.- a similar excuse as was used in Japan in the 80’s & 90’s to bring in free market policies,

    Early on in the crisis I remember Draghi constantly complaining about such things as collective bargaining, retirement ages etc, & the Brussels crowd have successfully used immigration from the most impoverished states as a weapon to degrade workers conditions in the more affluent ones – the IMF of course would also be fully on board with these aims. I imagine that in these distressed countries it would also be much easier to do a bit of asset stripping.

    Here is an interesting piece of history regarding central banks from post war Japan, Thailand, Korea, Indonesia, the US & finally Europe based on a book by Richard Werner, which was posted by Jesse & also on David Malone’s blog. It concludes ( I think ) – that central banks are basically looting machines, but perhaps you already knew that.

  8. William C

    Only marginally relevant but many years ago Draghi visited the organisation I was working in at the time. He was already quite famous, though it was pre-ECB. After the meeting folks were in the lift (elevator) talking about him. Some one said how intelligent he was; another how charming he was; a third how rich he must be, having worked at GS; a fourth said how handsome he was.

    From the back came the incredulous voice of a young woman: ‘who is this guy?’.

    1. craazyman

      I would have answered “Satan”, Just for the hell of it, no pun intended.

      ha haha ahahhahaha ahahah. It’s OK. Women love Satan. In theory anyway. I would’t put a young Dr. Draghi on that pedestal though. Maybe just a low-ranking demon with a whip. He was probably just feeling his way down the circles of the inferno of economics.

      Too bad all those good looks, intelligence and talent got wasted on something as ludicrously inane as economics. He could have been an electrician or a cowboy actor in Western movies. It doesn’t matter that he’s Italian. Sergio Leone made some very excellent westerns backk in the 1970s. I’d watch them again right now if I had to! Draghi could look out from under a hat in the sun and squint. Some little kid asks him “They say there comin tomorrow Doc. They’re gonna kill you and burn the town until it ain’t here no more. That’s what they say. That’s what they’re all sayin. What are you gonna do?”
      He puts an ammo clip into one of the two Winchester 30-30s tied to his saddle and squints out at the hard desert that starts at the end of the town’s one street .
      “Whatever it takes. And believe me, it’ll be enough”
      you can almost see it in your mind like a movie in the dark! hahaha

  9. Dino Reno

    The Masstricht treaty rules out deficit spending of member states so by purchasing the bonds of those states that run deficits it be would encouraging and sanctioning the very behavior it forbids. Draghi is therefore bluffing, but today he looked tired and despondent like he knew the game was up. He bought about 18 months of time, hoping things would right themselves, but today he coughed up a hair ball performance. With assets values stretched to perfection, drifting is not an option anymore. That’s how we got here.

  10. Jay M

    Basically he is in if they eat dog food, feed them dog food, territory which is what QE is all about and ZIRP.
    He will eventually be served a plate full.

  11. Lakshminarayanan

    The article seems to imply that ECB by not doing what US has done has got it all wrong. Yes, US has grown but at the cost of ZIRP, ballooning Fed BS, increasing moral hazard and speculation, asset bubbles all over the world and simply throwing the savers under the bus… all in the guise of doing good for the main street. The only thing probably that the Fed did right was staunching the edifice from crumbling in 2008/2009. The final word is not yet in on the other actions. We have to wait how it plays out now that QE is temporarily done with. Let us see how it pans out if and when the Fed raises rates.
    In short, there are too many risks to the system even now that one cannot say that the Fed has got it right. Even if they have let us see what the cost is going to be. It could well turn out that being tied to the German pole may not be a bad thing after all for the ECB.

    1. Greenbacker

      You really don’t understand capitalism. Asset bubbles are all over the world and always all over the world. They were there in 1630’s Amsterdam. in 1730’s UK, in 1850’s US, In 1890’s France, they are always there and always will be. Stuff like “QE” and “Zirp”(which is a myth as well) are irrelevant. They are window dressing. Lets note 2008-9 was not a solvency issue like first believed, but a trust issue. The debt was suspended and once the trust was restored, thus the system restored itself with the same debt. The “Fed” balance sheet is not where you should be looking. Structural based issues have always been with capitalism and always will be.
      The problem is capitalism. It is a usury based system thats real goal is for everybody to own each other.

Comments are closed.